Bear market checklist: How to spot when it's time to sell

 
Mike Bell
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Stock markets have historicall returned 40 per cent on average in the last two years of a bull market (Source: Getty)

As the current bull market ages and valuations no longer look cheap, investors are naturally starting to wonder how long it will be until the next bear market – a fall in equities of over 20 per cent that is nearly always associated with a recession being on the horizon.

The US is the closest to the end of its economic cycle and is the most important economy for global markets. Below are five key US indicators to keep a close eye on. Thankfully, at the moment, none is a cause for concern. But all of them have historically warned when the US economy, and hence global stock markets, are vulnerable to a sharp decline in the near future.

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First: initial jobless claims – the number of people who lost their job and filed for unemployment benefits over the past week. Going back to the 1990s, there is a tight pattern: shares tend to fall as the trend in initial jobless claims rises. On the positive side, this indicator is close to the lowest it has been in over 40 years.

Second: consumer confidence. A large dip in consumer confidence has tended to signal bad news for equities. In 2007, for example, consumer confidence started falling sharply before equities sold off. It has, however, risen strongly recently, jumping in March to its highest level since December 2000.

Third: the US ISM Manufacturing PMI (Purchasing Managers Index). This indicator is based on a survey of private companies and acts as a gauge for the economic health of the manufacturing sector. Readings above 50 indicate expansion and below 50 indicate economic contraction. In the past, large market falls have tended to coincide with this indicator falling below 50. The latest report for March came in at 57.2, consistent with strong economic expansion.

Fourth: the number of homes being built in the US. In a healthy economy, people are more likely to purchase new homes. Conversely, if they’re feeling nervous about the economy, they are less likely to buy a property – and as the outlook for the housing market weakens, the construction industry responds by building fewer homes.

The pattern here is that sharp downturns in US home-building (called housing starts by economists) often predict bear markets. By 2006, for example, this indicator was flashing a bright red warning sign that there were serious problems in the US housing market, before the equity markets realised what was going on. The current trend remains positive, with housing starts still well below pre-crisis levels but close to a 10-year high.

Our last warning signal is the US Conference Board Leading Economic Index. This is put together by a not-for-profit research organisation as a way of forecasting future economic activity based on 10 key variables. It combines these several components in order to help signal inflections in the business cycle and to smooth out some of the volatility of individual indicators.

This indicator has historically turned downward before a recession, successfully warning of every recession in the last 50 years. Sharp declines in this index tend to warn of trouble ahead for equites. Again, there are no warning signs of an imminent sell-off.

Watching several indicators to judge when a turn in the economy is likely to lead to a bear market is an important part of navigating the late cycle stage of a bull market. A mixture of indicators across the labour market, business and consumer confidence, manufacturing and housing suggest that there are no immediate concerns that a looming recession could spell the end of the global bull market run.

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It is reasonable for investors to keep an eye on valuations that are somewhat high, but it is worth bearing in mind that, historically, valuations haven’t been a particularly reliable indicator of turning points for the stock market.

Finally, investors who are considering taking their profits at this point and turning to cash should consider that history teaches us that the performance of shares in the last leg of a bull market tends to be strong. On average, stock markets returned almost 40 per cent in the last two years of a bull market and 25 per cent in the last year. For investors thinking of going to the sidelines now, that is a lot of upside potential to sacrifice.

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